Accounts Receivable and Inventories

This article concerns the basic accounting principles for tracking accounts receivable and inventories, and how this relates to running an effective business. Whether the business entity is a small entrepreneurial enterprise or a large publicly traded corporation, maintaining sound accounting principles will help to ensure that the organization is well run and profitable. Both types of entities need to track business costs and maintain sufficient cash flows; and publicly traded corporations also need to ensure that their financial statements are accurate and in compliance with the Sarbanes-Oxley Act.

Keywords Accounts Receivable; Business Model; Cash Flow; Channel Stuffing; Compliance Officer; Controller; Defaulted Receivable; Delinquent Receivables; Factoring; Financial Statements; Generally Accepted Accounting Principles (GAAP); Inventories; Invoice; Just in Time (JIT); Sarbanes-Oxley Act (SOX); Securities Exchange Commission (SEC)

Finance > Accounts Receivable & Inventories

Overview

Effectively tracking accounts receivable and inventories is a necessary condition for running a successful business enterprise. In short, both small business owners and officers of publicly traded companies need to know how much money is owed to the business for work it has performed or the goods, services and merchandise it has provided on a credit basis. This is the definition of accounts receivable.

Not only must business owners and executives have a system for tracking accounts receivable, they must also be able to track the goods, services and merchandise they can actually deliver, or its inventories. A company that does not maintain sufficient inventories will not be able to deliver these assets to customers, and this will be detrimental to customer relationships. On the other hand, if a company has inventories that cannot be sold, the costs incurred in maintaining those assets, that is the actual dollar cost of as well as the risks associated with warehousing goods while not having a market for them, will increase the business expenses and adversely affect the company's profit margin.

Applications

Accounts Receivable & Cash Flows

In order to keep track of accounts receivable, a company needs to establish a billing procedure. This will allow a customer to understand the terms of payment and give the company a method to keep accounts receivable current. The first step is for the company to provide the customer with an invoice and to have a system in place for tracking its invoices, such as a ledger.

Invoices

Invoices should be prepared on a company's stationery and indicate the items that were purchased (or the goods and services that were provided), the date of the purchase, purchase price (including applicable taxes and delivery fees), delivery date, invoice date and terms of payment — that is the due date, payment amount and the means of payment. The latter includes cash on delivery, check, money order, and credit card, as well as electronic methods such as PayPal, Square, and Safaricom's M-Pesa.

Of course, sending an invoice by whatever means (e.g., mail, email, telecopy) may not guarantee payment. So there must also be a procedure to handle payments and late payments. Usually, a customer who fails to pay by the due date after they have been provided with an initial statement is notified by mail or email, and then a follow-up call is made. In the event payments are not made, third-party collection agencies can be utilized to collect overdue payments, and if payments are still not made, further legal action may be required. One way to mitigate late payments is to have fewer payment terms; in particular, payments should be made in full by a certain date, and a penalty should be applied to late payments.

Working Capital & Cash Flow

For accounting purposes on income and financial statements, and in accordance with Generally Accepted Accounting Principles (GAAP), accounts receivable are listed as assets even though the cash is not on hand. Further, the cost of providing credit to customers is also a significant element in determining a company's working capital. A company's working capital is determined by cash flows, that is, an entity's cash receipts less its disbursements for a specific time period. Ultimately, a successful enterprise is one that has sufficient cash flows that will generate profits. Effective management of working capital will not only improve a company's profits but also reduce the risk of uncollected or delinquent receivables.

One way to enhance cash flow is to quickly collect accounts receivable by simplifying the invoicing process, minimizing payment terms, and having a collections procedure in place for delinquent accounts. Even if all these mechanisms are in place, a company still can experience problems collecting receivables and thus run into cash flow shortages. However, there is a means to mitigate the risk of late, uncollected or defaulted receivables, called factoring.

Factoring

Basically, factoring is the outright sale of a firm's account receivables to a third party. At one time, factoring was not viewed favorably; however, it is now a widely accepted and customary business practice. According to Feast (2013), research company BDRC reported that the use of such external financing as asset-based lending, invoice discounting, and factoring by UK small businesses increased to 21% in the second quarter of 2013, up from 15% in prior quarters.

But more importantly, it is good business management that enables a company to have sufficient working capital.

Factoring is usually made on a non-recourse basis. This means that the third party to whom the receivables are sold (the "factor"), is solely responsible for collection of the receivables. In so doing, the factor also assumes the risk of uncollected or defaulted receivables. To offset this risk, the sale of the receivables is usually made at a discount of the account's value. There are other forms of factoring, such as "recourse factoring" and "invoice discounting."

In short, factoring will enhance cash flows since payment of invoices becomes immediate. Ultimately, efficient cash flow will enhance a company's ability to re-invest in the company as well as to invest in interest-bearing investments. Effectively tracking accounts receivable is one tool for managing working capital that can enhance profits.

Inventory & Cash Flows

Another essential component of managing working capital is the effective management of inventory. This is a complex but necessary task since excess inventory (like uncollected or defaulted receivables) can adversely affect cash flows. At the same time, insufficient inventories can result in lost sales and delays for customers — and if such delays become a pattern, customers will seek out a company that can provide goods and services expediently. Not only will this affect a company's profits, but lost sales and lost customers can also have a significant adverse impact on a company's professional reputation — a bad name is bad for business.

JIT Manufacturing

One key to effectively managing inventory is to know how quickly stock is moving, and this can vary depending on the type and size of the business. Today, for example, many large manufacturing companies utilize a Just-in-Time method for maintaining inventories (JIT). This means that all the components of the good being manufactured on a particular day are delivered early that morning — no earlier or later (Flanagan 2005).

JIT inventorying reduces manufacturing costs since JIT stocks take up little space and this reduces the need for warehousing. Supplies that remain warehoused for excessive periods of time have a greater propensity for being damaged, and in some cases such supplies can become obsolete, and there is no market for obsolete goods. The key for a company is to determine which supplies move quickly and which move slowly. Inventory that does not move quickly means that cash flow will be hindered.

Although the JIT method reduces manufacturing costs, it should be noted that profitability ratios (such as return on assets, return on equity, and basic earning power) that aggregate all of a firm's activities may not be suitable metrics to determine the effect of JIT and lean manufacturing methods on a firm's financial performance (Klingenberg, Timberlake, Geurts, & Brown, 2013).

As with accounts receivable, for accounting purposes, inventories are listed as assets on a company's balance sheet — but this does not mean that inventory is cash. In addition to employing JIT, there are other ways to achieve inventory reductions and therefore enhance cash flows. The goal here is to reduce the time it takes to deliver goods and services to a customer. There are three means to reaching this end: Increasing sales, decreasing production and disposing of obsolete inventories.

Increased Sales

If sales rates are increased to the point that sales exceed creation of inventory, the amount and value of the inventory will decrease. Increasing sales rates are directly tied to the company's business model — included in that model should be an effectively trained sales force that is aware of inventory levels and the related pricing options. Moreover, the administrative costs associated with maintaining and training a sales force must also be minimized.

Reduced Production Rates

Another way companies reduce inventory is by reducing production rates, and this is greatly determined by demand. If demand is declining, then production rates obviously need to be decreased. In addition, the business needs to consider another cost associated with maintaining inventory — labor costs. There are a number of ways to reduce labor costs: cut shifts, hold wages steady, or by reduce the workforce when needed.

Obsolete Inventory Disposal

Finally, there is an accounting mechanism in place for reducing inventory. A company can resort to declaring its inventory obsolete and disposing of it. The expense associated with this a permissible write off in accordance with GAAP. This can be considered an expense that reduces profit and which likewise reduces taxable income.

In the end, reducing inventory frees up cash for other investments, and this will be reflected in the company's books and records or its financial statements.

The Accuracy of Financial Statements

In addition to the business basics associated with accounts receivable and inventories, and the need for effective management of these items to ensure cash flows that enable a company to have sufficient working capital to cover its business costs, reinvest in the company, or to invest in interest bearing investment vehicles, there is another crucial matter to consider — the accuracy of financial statements.

As we have seen, accounts receivable and inventories are considered assets on a company's income statements and balance sheets. For a small, non-publicly traded company, these items must be accurately reflected on its income statements as those will be included in its federal and state income tax filings. If these items are incorrectly booked and subsequently incorrectly reported to tax authorities, the consequences can be significant.

For publicly traded companies that are required to file financial statements with the Securities Exchange Commission on a quarterly basis (such filings are made on "Form 10-Q" and must be filed within 45 days of the end of a particular quarter) or on an annual basis (on "Form 10-K," now required to be filed within 60 days of a company's fiscal year end), the need for accurate financial statements has far-reaching implications.

SOX & Accounting Procedures

While the need for effective internal controls of accounting procedures are not new to the industry, the Sarbanes-Oxley Act of 2002 (SOX) imposed many new rules and procedures on publicly traded entities. First and foremost, executive officers are required to attest to the accuracy of the financial statements, under penalty of perjury. Moreover, there are numerous internal controls required to ensure that financial statements are accurate. These controls not only relate to the actual quantitative accuracy of financial statements, but also require audits of all corporate functions. Each and every business group, from the controller's office right down to the document retention functions are required to undergo thorough and exhaustive internal examinations to ensure that all the company's policies and procedures are being followed.

As SOX has worked its way through the business community over the years, various accounting deficiencies have been discovered. With respect to determining revenue, numerous companies have been shown to have deficiencies in their revenue recognition policies. These deficiencies are usually related to the timing of revenue recognition as well as contracting practices (Weili 2005). The timing of revenue recognition and contracting practices are directly related to accounts receivable, accounts payable, and inventory accounts.

Channel Stuffing & Invoice Backdating

Essentially, certain companies were found to have practices that were deemed to be improper revenue recognition. One such practice has been termed channel stuffing. This is a scheme whereby a company attempts to boost sales results by shipping more products to subsidiaries or vendors prior to the end of a reporting quarter (Weili 2005). This gives the appearance of higher sales figures, and reduced inventory, and thus greater revenue for that quarter. Another deficient practice that has been revealed concerns the treatment of accounts receivable. Certain companies were found to have been back dating invoices in an attempt to lower their outstanding or uncollected receivables for a particular quarter which gave the appearance of greater cash flows at the close of a quarter.

In any case, manipulating financial statements is an egregious violation of the Sarbanes-Oxley Act. By employing such devices, not only have companies (and the responsible individuals) been convicted of fraud under SOX, investors have also suffered undue hardship as the value of the companies stock price has fallen dramatically in these cases. And this has opened a Pandora's Box of class action lawsuits. Defending against these suits can be quite expensive and this can have a material adverse affect on a company's profits and its reputation as well as its viability as a business entity.

Not only have violations and deficiencies discovered by virtue of SOX proven to be costly, implementing policies and procedures to ensure compliance with the Act have also increased the cost to conduct business. In order to perform the required extensive internal audits and to verify that responsible individuals connected to accounting procedures are well trained, many companies have had to add significant personnel to their staff or to outsource these functions to consultants, and the increase in labor costs has had an impact on working capital.

Conclusion

Accounts receivable and inventories might seem like a mundane matter, but this is not the case. The complexities involved in accurately tracking and managing receivables and inventory require an expertise in accounting. More importantly, it requires a business entity to have "best practices" in place aimed at maintaining business ethics. Accounting expertise and business ethics are intangible assets that will have a serious effect on a company's bottom line, positively or negatively. As a result, it is necessary to have effective systems in place.

Accounts receivable essentially represent the value of the goods and services a company provides. This value is directly related to the company's profitability. Having efficient systems for invoicing and collections enables a company to mitigate the time it takes to get paid for items it has basically sold on credit. Moreover, having a handle on outstanding accounts receivable enables a company to devise a strategy for enhancing cash flows. As we have seen, one such approach is factoring. The outright sales of an entity's receivables will enhance cash flow — albeit the receivables are sold at a discount of the original value of the good or service. However, effective accounting procedures will result in adequate pricing models that will ensure profitability.

Inventories are the actual goods or services that a business entity provides to customers. The amount of time it takes to deliver these goods and services to customers also affects available working capital. Items that remain in inventory for excessive periods become costly as they are more likely to be damaged, or can become obsolete. While there are ways a company can mitigate losses for obsolete merchandize by permitted write-offs, business enterprises are established to sell goods and services, not to have their products become obsolete. A company needs to have a responsible individual aware of what is in inventory, and this information must be effectively communicated to its sales force. An effectively trained sales force can use this information by knowing what pricing models to employ. At the same time, sales managers can use this information and develop unit based incentives for its sales staff in order to increase sales rates.

Not only is effectively managing accounts receivable and inventories a crucial function in establishing business plans and models, such management enables a company Controller as well as the responsible Compliance Officer to establish policies and procedures throughout all the company's business lines to ensure compliance with SOX, and to guarantee that the financial statements accurately reflect the company's financial well being at any given time.

In the final analysis, a company that fails to have "best practices" in place for maintaining accounts receivable and inventories will not be profitable and can, if public, subject itself and its employees to criminal prosecution. Moreover not adhering to these practices can cause unnecessary losses for its investors and eventually trigger regulatory scrutiny and legal actions that will hinder business growth. Having qualified accounting and compliance personnel is one way to prevent these things from occurring and will prove quite beneficial to a company's profits, and that is the bottom line.

Terms & Concepts

Accounts Receivable: Money owed to a business entity for goods, services and merchandise purchased on a credit basis.

Business Model: The means by which a company generates revenue and profits, how it serves its customers and the strategy and implementation of procedures to achieve this end.

Cash Flow: Cash receipts minus cash disbursements from a given operation for a specific period. Cash flow and Cash Inflow are used interchangeably in accounting terminology.

Channel Stuffing: A manipulation of revenue on a company's books where sales results are boosted by shipping more products to subsidiaries or vendors prior to the end of a fiscal quarter.

Compliance Officer: Responsible individual in a company who ensures that procedures adhere to applicable Federal, state and regional laws, rules and guidelines.

Controller: Responsible individual in a publicly traded company who maintains corporate financial books and records or financial statements.

Delinquent Receivables: Receivables that have not been paid by a customer by the due date (the due date is usually 45 days from the date of the invoice).

Defaulted Receivable: A receivable that has not been paid and is referred to a collection agency.

Factoring: Outright sale of a firm's account receivables to a third party (the "Factor") without recourse; that is the Factor is solely responsible for collection of the receivables. Accordingly, such sales are usually made at a discount of the accounts value.

Generally Accepted Accounting Principles (GAAP): Universally practiced principles established by the Financial Accounting Standards Board (FASB).

Invoice: A bill used by a person or business who provides goods or services to a customer.

Inventory: The name given to an asset of a business relating to merchandise or supplies on hand or in transit at a particular point in time.

Just in Time (JIT): A method for maintaining inventories where components of a good being manufactured on a particular day are delivered that morning — no earlier or later.

Securities Exchange Commission (SEC): Federal regulatory agency responsible for enforcing the federal laws regarding the purchase and sale of stocks, bonds and other investments. One such law is the Sarbanes-Oxley Act of 2002.

Sarbanes-Oxley Act (SOX): Federal law enacted in 2002 that requires executives of publicly traded companies to attest to the accuracy of its financial statements and which also requires the establishment of extensive internal procedures and controls to ensure compliance with the law.

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Suggested Reading

Lavingia, N. (2006). How to create a world class project management organization. Ace International Transactions, 1.1-1.5. Retrieved November 29, 2006, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=22646735&site=ehost-live

Teague, P. E. (2006). How to speak like a CEO. Chemicals Edition, 135, 34-37. Retrieved November 29, 2006, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=20785047&site=ehost-live

Nagarkatte, A. (2006). The small business customer is ready to switch — For payment products. Banking Strategies, 82, S2-S8. Retrieved November 29, 2006, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=20827808&site=ehost-live